ESG investing has gained prominence in recent years as caring for people, and the planet have become pressing goals for many.
The importance of ESG investing has also gained momentum since the COVID-19 pandemic struck but was well underway before that. Many funds have already integrated ESG factors into their core, and companies are increasingly aware of having to tick ESG boxes if they wish to remain relevant and survive.
However, the transition is not as straightforward as one might believe. Multiple factors converge, and numerous trade-offs are taking place as companies weigh up their options.
The Environmental aspect of ESG
When looking at the environmental part of ESG, it is important to put this in the context of the world events that are impacting this area. Events such as COP and the signing of the Kyoto Protocol have undoubtedly had a huge sway on how businesses conduct themselves, affecting their credibility as companies worth investing in.
What is COP?
The COP is a 'Conference of the Parties', and it is the supreme body governing an international conference. The COP brings together parties to organize the greater good of the planet. The 26th UN Climate Change Conference, COP26, takes place in Scotland in 2021, with the previous having taken place in Madrid (after Chile canceled) in December 2019. Possibly the most memorable was COP21, which took place in Paris in 2015 and brought us the Paris accord.
The Paris Agreement is a legally binding international treaty on climate change. It was adopted by 196 parties at COP21 and brought into force on 4 November 2016. Its goal is to limit global warming to well below 2, preferably to 1.5 degrees Celsius, compared to pre-industrial levels.
The rise of renewable energy and electric vehicles
Renewable energy is seen as the holy grail of climate action. It will transition the world to a cleaner planet with a clear conscience. But it is not as easy as it sounds, and the transition comes with its own unique set of challenges.
Nevertheless, one clear winner in the race to renewables is the electric vehicle. Far from being a non-starter, the rise of the electric vehicle has taken the world by storm and is on track to replace traditional vehicles in the next few years.
Tesla (NASDAQ: TSLA) remains the clear leader in this space, but many traditional carmakers are catching up. The space is rife with start-ups, and several EV companies have already crashed and burned, but some potential winners have seen their share prices rise.
Striving for an electric planet
Electricity is the power that renewable energies strive to produce. Renewable options include hydrogen, wind, solar, hydro, tidal, geothermal, and biomass, along with carbon capture initiatives.
The material used in producing nuclear power is not renewable, but nuclear energy is another potentially environmentally friendly solution to generating electricity.
Each of these energy sources offers a prospective route to reducing our carbon footprint. Unfortunately, none are yet in a position to solve the world's problems single-handedly.
Nevertheless, for investors, each of these areas of environmental progress offers a raft of publicly-listed companies to invest in.
The decline of Oil, Gas & Coal
The coal industry's demise was easily justified, and replacing it with cleaner alternatives is not too arduous an undertaking. However, it is still heavily relied upon in emerging markets, particularly China, and phasing it out entirely is expensive.
Oil and gas, on the other hand, are not so easily displaced.
In recent years, financial institutions have boycotted these industries as investment in ESG-friendly alternatives gained precedence. While well-meaning sentiment can drive narratives, the fundamentals are left to speak for themselves.
Reducing the carbon economy before the green economy is ready to roll seems a relatively foolish endeavor, leading down the dangerous path to much higher energy prices. If production declines to the point supplies are limited, and demand carries on increasing, then prices will rise.
Indeed, there are already clear signs this is underway.
Now that demand for oil and gas is rebounding, their prices are rocketing. The reason this is dangerous is inflation. If energy prices are high, company costs spiral out of control, and what was once a profitable business can quickly become unviable.
Meanwhile, the economy suffers if people can't afford to keep the lights on, put food on their tables, and fuel in their cars.
Every business has a carbon footprint. To reduce their footprint more quickly, they can buy carbon credits to finance projects that reduce or absorb carbon emissions around the world. This provides a way for less ESG friendly companies to offset their carbon emissions.
Tesla is producing electric vehicles and therefore considered environmentally friendly. It makes a lot of money from selling carbon credits to traditional automakers that are not yet on a green path. This may seem like a cheat, but it is a legal cheat, and the carbon credit business is likely to get much, much bigger.
The Social aspect of ESG
Socially responsible investing (SRI) has taken on a life of its own in recent years. While some investors have avoided sin stocks such as gambling, weapons, and tobacco for decades, nowadays, investors are becoming much choosier about where to put their cash.
One of the biggest pitfalls of socially responsible investing is the belief these investments lack the opportunity to profit. But this view appears to be changing.
SRI as a strategy covers all aspects of the ESG framework. Therefore, companies that look after their employees, protect the environment, avoid bad press, and generally behave as upstanding citizens are much more likely to succeed long-term.
The most attractive aspect of SRI is that investors sleep easy with the confidence their investment is for the greater good.
G stands for Governance
Effective corporate governance is vital in steering a company in a positive direction. It identifies who has power and accountability and who makes decisions. The intricate complexities of corporate governance could fill many books, but in a nutshell, good governance incorporates managerial responsibility, board structure, and shareholder rights.
Corporate governance is something every single company should consider. Whether public, private, big, or small, the way a company is governed speaks volumes to its success.
Bull case for ESG Investing
ESG Investing is here to stay and at its heart is an altruistic desire for the common good. Companies embracing the circular economy are meeting consumer desires to improve and thus enhancing their attractiveness as investments.
Aligning profits with principles is an honorable quest and not likely to disappear anytime soon. Technology is paving the way for many innovative start-ups to shine in the years ahead.
Such offerings as lab-grown meat, vertical farming, and aquaculture could revolutionize the food industry and solve global hunger with much less pollution.
Fast fashion could be replaced with sustainable alternatives and more environmentally friendly fabrics made from unique agricultural by-products such as pineapple leaf and leftover vegetables. There are already several start-ups making progress in this space. Meanwhile, fashion swap sites and clothing rental businesses have increased in recent years.
Construction is being shaken up with innovative ways to produce environmentally friendly concrete.
Bear case for ESG Investing
Despite the desire to transition to renewables and terminate all investments in fossil fuel and high emission stocks, the reality is not that simple.
The modern standard of living is achieved thanks to oil and gas. Construction is another key player, but it too continues to be a significant global polluter. For instance, the construction industry remains heavily reliant on coal to turn iron ore into steel.
Electricity requires natural gas, which is burned to spin turbine blades. The gas is more environmentally friendly than coal-fired generators, but it still produces some greenhouse gases.
Demand for these dirty commodities is not slowing. In fact, it is increasing. Countries like Africa, India, and China are all transitioning to a higher standard of living. But to do so requires massive construction projects and the burning of fossil fuels.
Energy consumption and global warming are linked. Sadly, the countries likely to suffer most from the devastating effects of climate change are those that have done the least to cause it.
“Some people have wasted energy, but others haven’t had anything to waste.”
- Jimmy Carter Energy and the National Goals - A Crisis of Confidence delivered 15 July, 1979
Modernizing the power grid requires batteries on a massive scale, massive storage capacity, ultra-high voltage, and ordinary power lines, turbines, transformers, power flow controllers, and an exponential number of semiconductors to move to these cleaner sources. All of which require natural resources from base metals to rare earth minerals and natural gas.
For the world to truly transition to a carbon-free existence, it seems a phase of discomfort is to be expected. For now, we may have to accept that a period of temporary blackouts and high energy prices are par for the course.
There are many proposed solutions, but trial and error combined with unprecedented spending initially appear to be the only way forward. Nevertheless, some exciting products and services are already popping up, proving the transition to a carbon-neutral future is well underway.